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Cross section of option returns and idiosyncratic stock volatility

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  • Cao, Jie
  • Han, Bing
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    Abstract

    This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.

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    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X12002450
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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 108 (2013)
    Issue (Month): 1 ()
    Pages: 231-249

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    Handle: RePEc:eee:jfinec:v:108:y:2013:i:1:p:231-249

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Option return; Idiosyncratic volatility; Market imperfections; Limits to arbitrage;

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